Natural gas looks for support in long-term conversions

ESTABLISHED TECHNOLOGY! The technology to modify a conventional diesel engine to run on a mix of diesel and natural gas has been around for decades. BNSF considered using gas-powered locomotives in the late 1980s, according to the WSJ. Leading engine makers General Electric, Caterpillar and Wartsila all offer a variety of dual-fuel models that can run on a mix of up to 90% natural gas and 10% diesel.

In 1998, the California Energy Commission and the U.S. Department of Energy and the Southern California Gas Company helped the City of Lompoc retrofit four municipal buses with dual fuel gas engines from Caterpillar, using compressed natural gas (CNG), and studied their performance over a 12 month period. Most dual fuel engines rely on diesel to start up and continue to use a small amount to provide ignition (the ignition temperature of natural gas is too high to be used on its own). But once the engine is running, natural gas can provide as much as 50%-90% of the fuel used with no loss of performance. The engine can also revert to using 100% diesel if gas is not available.

RUNNING VERSUS CAPITAL COSTS! Retrofitting diesel engines so they can run on dual fuel is expensive but not prohibitively so. In the City of Lompoc case study, it cost $45,000 to retrofit each municipal bus. The WSJ reports that retrofitting a diesel locomotive and adding a tanker to carry the LNG could add up to $1 million to the normal $2 million price tag of a locomotive for BNSF.

For retrofitting to make sense, the difference between gas and diesel prices must be large enough to allow the operator to recover the upfront capital costs of retrofitting quickly to make it worthwhile and minimize the financial risk.

For most of the last four decades, there has been a small price advantage for running on gas, but not big enough to justify the upfront costs of retrofitting, and the need to invest in all the associated infrastructure for liquefying the natural gas and deliver it to refuelling stations. But the shale revolution has resulted in a big and persistent disconnect between gas and diesel prices. Since the wedge is expected to last, the financial incentives for retrofitting are enormous.

Gas is currently priced at around $3.60 per million British thermal units (mmBtu) in the futures markets. By contrast, a gallon of diesel costs almost as much ($3.00) for just one-seventh of the same energy (137,190 Btu). If natural gas and diesel were priced at energy parity, gas should be trading at $21 per mmBtu, or diesel should cost just 49 cents per gallon.

These are wholesale prices and do not include the cost of distribution. Nor do they include the cost of chilling, pressurizing and liquefying the natural gas so it can be used in CNG and LNG engines. Even so they provide an indication of the huge price advantage. The savings on operating costs are so large that the payback period for most retrofitting projects is just 1-2 years, which substantially reduces the risk of making the capital investment. Moreover, once dual fuel engines have been installed, the owner has complete flexibility over how to operate them. If gas prices rise again, or the cost of diesel falls, engines can revert to running on diesel.

SCOPE FOR SUBSTITUTION! Potential for substitution is greatest in North America, where oil and gas prices have diverged most sharply following the shale revolution. In regions like Asia where gas prices are partially or wholly linked to oil, the price advantage is smaller. But Japan has already begun to push for revisions in its LNG contracts to reflect cheaper prices in the United States and elsewhere. And China also appears to be eyeing the potential for rising domestic natural gas production to replace diesel in some transport and industrial engines. The fuel industry displays enormous amounts of institutional inertia. But for the same reason, it can display abrupt discontinuities when the pressure for change passes as critical threshold.

In the 1860s, British economist William Stanley Jevons was confident oil could never replace coal as a transport fuel. Winston Churchill's decision to shift the Royal Navy's battleships to oil on the eve of World War I was seen by contemporaries as either daring or foolish. Within just over two generations, however, coal's place as a transport fuel had disappeared. If gas and oil prices remain disconnected, straight diesel engines without dual fuel capability might one day seem as antiquated as coal-powered warships. The more likely outcome is that the growing threat to diesel's market share will force re-convergence between oil and gas prices, as soaring demand for gas pushes prices higher, and falling demand for crude pulls prices back.

About the Author

Senior energy analyst at The PRICE Futures Group and a Fox Business Network contributor. He is one of the world's leading market analysts, providing individual investors, professional traders, and institutions with up-to-the-minute investment and risk management insight into global petroleum, gasoline, and energy markets. His precise and timely forecasts have come to be in great demand by industry and media worldwide and his impressive career goes back almost three decades, gaining attention with his market calls and energetic personality as writer of The Energy Report. You can contact Phil by phone at (888) 264-5665 or by email at pflynn@pricegroup.com. Learn even more on our website at www.pricegroup.com.

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